Tax Opportunities and Tax Traps for Real Estate Transactions
The new tax rules that were enacted in the Tax Cuts and Jobs Act of 2017 (the "2017 Tax Act") significantly changed the tax landscape for real estate owners and developers. Among the significant changes included in the 2017 Tax Act are (i) the implementation of a new three-year holding period that applies to "carried interests," (ii) a new tax deduction that applies to flow-through entities like partnerships, limited liability companies and S corporations, and effectively results in a rate reduction for such entities, and (iii) new rules limiting the deductibility of business interest expense. With these tax law changes, owners and operators of commercial real estate now have more tools in the tool box to increase "after tax" returns. However, these tax law changes also lay potential "tax traps" that can end up creating additional tax costs if proper steps are not taken.
This article is not intended to be a comprehensive discussion of all of the tax law changes created by the 2017 Tax Act. Instead, the purpose of the article is to highlight some of the tax planning opportunities and pitfalls that a real estate owner might face under these new tax rules.
New Rules that Apply to Carried Interests
The 2017 Tax Act enacted new Section 1061 that imposes a three-year holding period on "applicable partnership interests." In general terms, Code Section 1061 applies to any promote or carried interest issued by an entity taxed as a partnership, including a multi-member limited liability company. Based upon the language of Code Section 1061, the three-year holding period applies to any interest issued by a limited liability company or partnership for which the share of distributions is not commensurate with the share of capital contributed.
Under the new rules of Code Section 1061, the three-year holding period applies to both the interest itself and to the share of taxable gain arising from a sale of property allocable to that interest. Thus, to the extent a carried interest is subject to Code Section 1061, even if the issuing limited liability company sells property held for more than one year, the gain allocated to the holder of the carried interest is not entitled to long-term capital gain treatment unless the holder has held the carried interest for more than three years. Instead, if the three-year holding period is not met, such gain is subject to income tax at short-term capital gain rates (which now have a top marginal rate of 37 percent).
Based on the legislative language, the making of a Code Section 83(b) election does not change the three-year holding period requirement. In addition, the three-year holding period may also apply to upper-tier limited liability companies that are commonly used to provide employees of a real estate company with a share of the carried interest as part of their overall compensation package. Note, however, that the use of a tiered structure may also provide planning opportunities to avoid the application of this three-year holding period.
This three-year holding period applies even if the promote or carried interest was issued prior to 2018. Because Code Section 1061 significantly changes the rules that apply to carried interests, understanding how the three-year holding period is applied and what strategies can be adopted to minimize the effects of these new rules must be taken into account in both new and existing structures.
The New Deduction Applicable to Flow-Through Entities
As widely reported, the 2017 Tax Act decreased the tax rate applicable to corporations to 21 percent. The 2017 Tax Act also includes new Code Section 199A which provides for a deduction of up to 20 percent of the net taxable income that flows through from a limited liability company, S corporation or partnership. The impact of this 20 percent member/shareholder-level deduction is to potentially lower the top tax rate that applies to flow-through income from 37 percent to as little as 29.6 percent.
This deduction is subject to several limitations, including a limitation that is based on the W-2 wages paid by the limited liability company, S corporation or partnership and the unadjusted tax basis of the depreciable property held by the limited liability company, S corporation or partnership. In addition, Code Section 199A provides that the deduction is not available for the flow-through of net income from the performance of services that consist of investing, investment management or dealing in interests in securities or from the performance of consulting, financial services or brokerage services. Code Section 199A also provides that the 20 percent deduction will not be available if the net income arises from any business whose principal asset is the reputation or skill of one or more of its employees or owners.
Because of the limitations on the availability of this deduction, some real estate companies may want to restructure their business into two or more separate entities in order to maximize the benefits available from it. In addition, in drafting agreements for limited liability company, S corporation or partnership that utilize tax distributions, the potential benefits from this 20 percent deduction should be addressed in the tax distribution calculation in order to avoid an over-distribution.
New Limitations on Deductibility of Business Interest Expense
The 2017 Tax Act limits the deduction for business interest expense to the sum of business interest income plus 30 percent of the business’s adjusted taxable income which for certain tax years is defined as EBITDA. This limitation applies to C corporations, S corporations, limited liability companies, partnership and other entities. Business interest not allowed as a deduction in a tax year may be carried forward indefinitely. Although small businesses with average annual gross receipts of $25 million or less are exempt from the limit, the exemption does not apply to "tax shelters" prohibited from using the cash method of accounting under Section 448(a)(3) of the Code. This definition of "tax shelters" may include partnerships and limited liability companies that are projected to generate net losses for federal income tax purposes. This new limitation is effective for tax years beginning in 2018, without regard to when the debt generating the business interest expense was incurred.
In the case of a partnership or limited liability company, the business interest expense limitation is initially applied at the partnership level. Disallowed business interest may be carried forward, but is allocated to each partner and the partner is entitled to claim it in subsequent years, but only to the extent of the partner's share of "excess taxable income" from the partnership. Similar rules apply for S corporations with the limitation is applied at the corporate level and similar carryforward rules.
Businesses engaged in real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trades or businesses may elect out of the business expense limitation. However, if this opt-out election is made, the electing entity must depreciate its property on a straight-line basis over 40 years for nonresidential real property, 30 years for residential rental property, and the applicable class life for other property. The making of this opt-out election may have other collateral tax consequences. In addition, the timing for when its election must be made is unknown. Thus, as additional guidance is issued by the IRS, real estate owners and developers will need to evaluate whether its opt-out election should be made.
Other Tax Law Changes
The 2017 Tax Act included several other changes that could affect owners of real estate and passive investors. For example, the 2017 Tax Act increased the amount and availability of "bonus" depreciation, created new limitations on the ability of noncorporate taxpayers to deduct "excess business losses," and eliminated the ability of corporate entities to claim tax-free treatment for property or cash contributed to them by governmental entities to assist development.